Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) should reach record-high operating EPS over the next two years, reaching nearly $16bn by 2014 (12.7% CAGR), with continued growth thereafter. In particular, GEICO, BNSF and the collection of Manufacturing, Service and Retail businesses (roughly 70% of 2013E earnings) should see record-high earnings. So says a new report from Nomura initiation coverage on Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B). Further details from the report below:
Nomura on Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)
Our Berkshire model assumes modest U.S. GDP growth near 3%, but with over 85% of the company’s revenues in the U.S., anything better for the U.S. would mean even greater Berkshire earnings.
Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) has a collection of best-in-class companies, which positions it well in nearly any environment. From strong brands to low-cost distribution models to dominating market shares or limited competition, all of the major Berkshire businesses have sustainable competitive advantages, in our opinion.
Accretive Cash Deployment Is Just a Bonus
- Our EPS and book value projections give no credit for the deployment of $35bn of cash in the hands of Mr. Warren Buffett. Given Berkshire’s reputation and financial strength, we believe there is potential for more high-profile deals with lucrative terms, such those struck with Goldman Sachs, Bank of America, or most recently, Heinz.
- The Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) board has pledged to repurchase BRK/A shares at 1.2x book, which we believe provides a solid floor for investors.
Valuation Does Not Reflect the Fundamental Outlook
- Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) is trading at 1.3-1.4x book value, below its historical mean of near 1.5x and below our sum-of-the-parts valuation of $184,000.
- We expect that the discounted valuation reflects concerns of whether Mr. Buffett can meaningfully continue to grow the huge Berkshire empire through his investing acumen, but this ignores the significant operating earnings of the empire that already exists. Operating company earnings drove approximately two-thirds of BRK’s intrinsic value creation in 2012, but we expect that to grow to be over 80% through 2014.
Investment Summary
We Initiate Coverage with a Buy Rating, $184,000 Target Price
Strengthening U.S. Consumer and Business
Given that Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s companies are generally best of breed and leveraged to the U.S. economy, we expect that as American businesses and consumers regain strength, the company will generate impressive operating earnings, including double-digit earnings growth through 2014. The transition to operating company earnings should drive book value growth, and Berkshire’s reputation and financial strength should enable it to strike deals on favorable terms. Our multiple-based, sum-of-the-parts valuation results in our $184,000 target price and supports our Buy rating.
Growing Earnings Power
We expect Berkshire’s earnings to ramp up quickly and to approach $16bn by 2014 (12.7% CAGR). Our model assumes modest U.S. GDP growth of near 3%, but with over 85% of the company’s revenues in the U.S. and serving American consumers and businesses, better growth for the U.S. would further enhance Berkshire’s earnings power.
In the Underwriting businesses, roughly 24% of revenues, GEICO continues to be a share gainer and should produce double-digit earnings growth, while unit count growth, driven by a growing economy, should help power GenRe. BHRG is aggressively entering the Lloyd’s market, which should further propel its growth rate over the next few years.
In the non-underwriting businesses, we expect combined earnings growth of roughly 11-14% from the various business segments. The railways are benefiting from the U.S. energy boom, economies of scale and the growth in online consumer spending as more consumers take advantage of low-cost shipping. The Manufacturing, Service and Retail (MSR) businesses are also well positioned for growth as both the American consumer and small businesses
increase spending.
The Bonus of Cash Deployment
We are emphasizing the transition to operating company earnings as the driver of value. That said, we believe our EPS and book value estimates are conservative, as they give no credit to the deployment of $35bn of cash currently on hand. Given Berkshire’s reputation and financial strength, we believe there is a likelihood for additional deals with lucrative terms similar to those high-profile ones struck with Goldman Sachs Group, Inc. (NYSE:GS), Bank of America Corp (NYSE:BAC), or most recently, H.J. Heinz Company (NYSE:HNZ).
Additionally, we note the board has pledged to repurchase shares at 1.2x book value, essentially creating a downside floor to the share price given its current valuation of roughly 1.4x book value.
Undervalued Shares
We attempt to value Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) using a sum-of-the-parts valuation methodology that assumes completion of the pending Heinz purchase. We use average peer multiples for most of the operating companies, but we have assigned premium valuations to reflect the strength of the franchises, where warranted.
Our assumptions lead us to value the shares at $184,000 per share, representing 15% upside potential from current levels.
In addition, more than simply producing American brands or being U.S.-based, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s businesses are typically in industries that serve other American industries. From insurance to manufacturing to transportation, Berkshire’s businesses are often the “oil in the machine” that powers much of the American economy. As the American economy improves (we assume ~3% GDP growth), Berkshire’s fortunes will rise as well, we believe.
Insurance/Reinsurance
The insurance/reinsurance businesses have provided the “float” that has allowed the genius of the company’s founder to flourish. We employ our years of experience following the insurance sector to analyze the major businesses of GEICO and the company’s reinsurance business (although Berkshire includes smaller specialty insurers, too).
To Investors of Berkshire Hathaway Inc.
Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) is an enormous and complicated company, in a way that is often underappreciated. Perhaps it’s the chairman’s silver-tongued ability to describe an esoteric business such as loss portfolio transfer in a folksy, business-for-dummies manner. Perhaps it’s the company’s scant disclosure. Perhaps it’s the belief that too much attention to the details would leave one too focused on the trees and completely lost in the woods.
Nonetheless, we attempt to analyze some sections of the proverbial elephant and make our best estimation of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) as a whole. To give context to our work, we stress that Berkshire is huge. Look at some of the company’s highlight bragging points:
- GEICO is the No. 3 auto writer in the U.S., ranked by 2012 net written premiums. With over 11 million policyholders, it has been growing premiums in the high single digits, with low 90s combined ratios.
- Combined to be the world’s No. 3 reinsurer, GenRe wrote nearly $6bn of premiums in 2012, while Berkshire Hathaway Reinsurance Group more than doubled that volume.
- BNSF Railway is a leading freight transporter with nearly 400 different railway lines, covering 32,500 route miles in the U.S. and Canada and growing revenue in the highsingle digits.
- MidAmerican Holdings has 7 million energy customers throughout the Midwest and the western U.S. and stable margins in the high teens.
- Berkshire owns hundreds of manufacturing and service businesses, such as building products (ACME, MiTek), leisure vehicles (Forest River), and chemicals (Lubrizol); it is a leading wholesale distributor for Wal-Mart and 7-Eleven.
- Major brands include Dairy Queen, See’s Candies, Brooks Sports, Fruit of the Loom, and Benjamin Moore.
- Berkshire also is a major participant in businesses such as real estate, furniture, jewelry, and newspaper publishing and has material positions in companies, such as Coke, Wells Fargo, IBM, and soon, Heinz.
Most of these companies were at one time stand-alone public companies with teams of analysts pouring over detailed quarterly reports and SEC filings. Berkshire also owns dozens and dozens of other businesses, nearly all of material size within their competitive marketplaces. Considering the company’s scope it’s no wonder that the details are often underappreciated.
As Mr. Buffett once said when discussing the problem of diversification back in Berkshire’s early days, “The problem with having a harem of women, is that you don’t get to know any of them very well” (Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) annual report, 1984). Given the immense scale and complex nature of this company, we focus on the key highlights and
drivers of each business segment in this report. For a more detailed view into the company, please see our model.
The Berkshire Empire: an American Empire
“A rising tide lifts all yachts” (Berkshire Hathaway annual report, 1995).
While Berkshire may be huge and global, the company’s businesses are largely focused on the United States. Nearly all of the various businesses’ headquarters are in the U.S. and the major assets and revenues are also largely American. We estimate that over 85% of the company’s revenues are “made in the U.S.A.”
In Fig 1, we show how over the past few years, Berkshire’s ROE and the U.S. GDP have closely tracked each other. And with the addition of companies such as BNSF, Lubrizol and Heinz folding into the mix, the correlation (r-squared = ~0.8) is likely to grow.
GEICO, the Ubiquitous Auto Insurer
The success of GEICO is impressive. The U.S. personal auto insurance industry is a fully mature market. With nearly every driver legally bound to buy insurance, the only industry growth comes with population growth (a little less than 1% a year). Yet GEICO has managed to report mid-to-high single-digit premium growth year after year.
The company’s low-cost distribution model has emerged as the winning model of the industry. GEICO is a 100% direct-to-consumer auto insurer. No agent commissions are paid and much of that savings is passed on to the customer (not coincidently, 15% or more). The model is simple but also difficult to replicate due to the importance of scale, brand, and issues around channel conflict for other insurers. Travelers, for instance, an industry powerhouse, has struggled for several years to build a direct auto business and remains below critical mass. Allstate’s attempt was also a disappointment, angering their agents, and eventually resulting in the high-priced acquisition of Esurance, the No. 3 and last remaining stand-alone direct auto insurer.
We would caution that GEICO is not without a “direct” rival. Progressive, just behind GEICO in the rankings, has at times surpassed GEICO’s growth rates. Progressive is famed for an innovative and aggressive culture that first developed credit-scoring as an underwriting tool and even led the development of widespread direct distribution models, including Internet sales, which power GEICO today. Currently, Progressive is threatening to shake up the industry with the development of “telematics,” a tool that will monitor policyholder driving habits and price accordingly. GEICO management has publicly declared little interest in such underwriting tools, but, in our view, telematics has the potential to create a major sea change in the auto insurance industry.
We expect GEICO to grow premiums in the high-single-digit range through 2014 and by leveraging a largely fixed expense structure to increase margin through double-digit earnings growth. The bigger GEICO gets, growing faster than the industry naturally becomes more challenging; but as consumers become more comfortable buying insurance online and with few direct competitors and GEICO’s low-cost advantages, we expect better-than-industry growth rates through at least 2018.
Reinsurance
Berkshire has two major reinsurance operations in General Re (GenRe) and Berkshire Hathaway Reinsurance Group (BHRG). General Re, a leading direct global reinsurer, was acquired in 1998 and proved to be one of Berkshire’s more difficult acquisitions.
The company required significant reserve additions and was affected by a high-profile legal case against a former manager. These issues, however, are behind it. Today, GenRe is fulfilling its promise of controlling significant market share but still maintaining underwriting discipline. The combined P&C and life/health operations have reported net underwriting profits in each of the past six years despite major loss quarters due to events such as the earthquake in Japan in 2011 or Hurricane Sandy in 2012. GenRe’s disclosure regarding some of its operations such as the Life/Health business, which produces $3bn of premiums, is limited. As prices in the reinsurance markets wane, we expect a flat top line for GenRe, with margins holding steady.
BHRG, led by Mr. Buffett’s favored manager, Ajit Jain (to whom shareholders have been urged to “bow deeply”), has been a spectacular success for Berkshire and is unique among the major businesses as the only significant home-grown operation. Unlike a typical reinsurer, BHRG is focused on one-off or special situation transactions. A BHRG contract is usually costly, but as the head of Lloyd’s once quipped after buying a major cover, “Our owners wanted to sleep at night, so we bought the world’s best mattress,” referring to BHRG’s financial strength and reputation. When an insurer wants regulators and investors to not worry about an issue, they call Mr. Ajit, as American International Group Inc (NYSE:AIG) did when it purchased asbestos protection. In addition to attractive underwriting terms, BHRG has significantly added to Berkshire’s “float.”
With revenues that are large and often lumpy—BHRG could report several billions of dollars of premiums written one quarter and zero the next—forecasting results is a challenge: 2013 likely will be weighed down by the expiration of the Swiss Re quota share contract, but we know the company was active during the April renewals in Japan and has made recent headlines with its entry into Lloyd’s with a major quota share written through Aon.
Float
When discussing the underwriting operations, the concept of “float” is important to understanding Berkshire. Most insurers and reinsurers attempt to position their investment portfolios conservatively, largely in fixed income investments with durations that match liabilities. Experience (stemming from an industry crisis in the 1970s) and regulatory pressure force this discipline. Berkshire, however, views its claims liabilities as assets to be invested to earn an attractive return before needing to be paid out. For this reason, the company has a special taste for long-duration liabilities such as asbestos. Mr. Buffett has described his views on float at length in his annual reports.
As critical as float may have been over the first several decades under Mr. Buffett’s leadership, we view that its importance has declined as the company has grown. As we later discuss, with the company buying 100% of large companies such as Lubrizol, Berkshire is becoming less and less of a quasi-investment vehicle and more of an operating company.
Make Way for Railways: BNSF Railway—the Former Burlington Northern Santa Fe
While railroads may have the reputation of being a business of yesteryear, the railway industry currently is experiencing a boom. Growth in U.S. energy demand has been one major driver, but the technological advances of things like fleets of “hot trains” that deliver consumer products for FedEx Corporation (NYSE:FDX) or Amazon.com, Inc. (NASDAQ:AMZN) have also contributed to the growth. Capital spending by the freight railway companies is at new highs (see chart below), as the industry expects increasingly long-term demand.
While the ups and downs of BNSF’s business are affected by the demand levels for its major products shipped, such as coal, agricultural products and industrial products, there has been relatively consistent growth in recent years despite the fluctuations of the U.S. economy. (Revenue and EBT CAGRs have been around 13-15% and we expect that to continue through 2014.) This has been driven by the rise in price of gasoline, making rail more efficient versus trucking, as well as the large amounts of capital improvements in the rail lines themselves. To illustrate efficiency, we note that in 2012 the rail industry could move 1 ton of freight 476 miles on one gallon of fuel on average, with the economies of scale favoring the largest players; this is a 100% improvement over 1980.
Of the major class 1 railroad companies, BNSF is really only challenged by Union Pacific (UNP) in terms of scale and performance. BSNF and Union Pacific Corporation (NYSE:UNP) rank first or second in just about every comparable operating metric, including total cars on line, average speed, tonnage moved, etc., as well as financial metrics including total revenues and margins.
The scale advantages are obvious, and with bigger meaning better, the large amounts of capex being deployed will likely only further the gap between BNSF and Union Pacific Corporation (NYSE:UNP) versus the other competitors, translating into even better revenues and margins. BNSF was estimated to be worth approximately $34bn when it was taken out. Given that UNP trades at approximately ~17x earnings currently, we have used our similar multiple for BNSF, equating
to a value of north of $60bn, which is in our sum-of-the-parts valuation analysis.
Utilities and Energy Businesses
Turn on the Lights: MidAmerican Holdings Company
Berkshire owns 89.8% of MidAmerican, a major global utility and energy company. Businesses include regulated utilities (PacifiCorp and MidAmerican), natural gas pipelines and a UK electric company (Northern Powergrid). MidAmerican also includes a real estate brokerage business. While growth rates slowed and margins tightened during the recent recession, the energy businesses proved to be remarkably stable in face of the downturn due in part to the regulated aspect of the business.
Coming off a slow-growth period during the prolonged economic weakness, the company should see a double-digit rebound in growth in 2013, slowing to a mid-single-digit rate thereafter, we believe.
Manufacturing, Service and Retail
The Manufacturing, Service and Retail (MSR) segment of Berkshire, accounting for approximately a third of Berkshire’s earnings, groups together a large number of diverse businesses, from NetJets to See’s Candies. Marmon, the largest operating company, includes approximately 150 manufacturing and service businesses itself and is organized into 11 business sectors, with the largest being Union Tank Car, which leases tank cars to shippers such as oil companies. McLane is a wholesale distributor of consumer goods to retail stores.
Other well known businesses are Acme Building, Benjamin Moore, Johns Manville, MiTek, Shaw, Lubrizol, Businesswire, TTI, Dairy Queen, Buffalo News, Borsheims and Helzberg Jewelers, Pampered Chef, and the list goes on. Among the major businesses of Berkshire and due to the more consumer-sensitive aspect of the retail operations, MSR has shown the most economic sensitivity among the portfolio of Berkshire segments, although, as we show below, profitability has remained intact.
The businesses in MSR enjoy advantages that include size and brand. McLane, for example, is the largest distributor to Wal-Mart. Brooks running shoes are known as costly but geared for “the running geeks.” Nebraska Furniture Mart is the largest home furnishing store in North America. As the U.S. consumer slowly recovers, we expect mid-teen earnings growth through 2014 at MSR.
Finance and Financial Products
“The Weapons of Financial Destruction”
The smallest of the major segments, FFP includes rental companies (XTRA and CORT), the leading producer and financer of manufactured homes (Clayton), Berkadia (a commercial mortgage 50% joint venture with Leucadia) and Berkshire’s position in the derivatives market. While the derivatives portfolio had received negative press due to Mr. Buffett’s prophetic “weapons of mass financial destruction” comments in regard to derivatives, Berkshire’s portfolios are long–term, plain vanilla credit default and equity index put options. While the portfolio’s value has shown the expected volatility over the past several years, there has been little cash collateral payments required, much as Mr. Buffett claimed when he first wrote the contracts. Given the difficulty in modeling the returns of the equity-market linked derivatives, we have modeled for flat earnings in this segment.
Heinz
Berkshire recently announced its intension to purchase 50% of H.J. Heinz (of ketchup fame). Berkshire will invest $4bn for common equity in the holding company and $8bn in preferred shares (which will pay a 9% dividend to Berkshire) with warrants to buy an additional 5% of equity. A small group of investors led by Brazilian businessman Jorge Paulo Lemann will own the other 50%.
“All I Want in Life Is an Unfair Advantage”
“A growing capital base is a problem like aging, it is better to have it grow than to be “solved” (Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s annual report, 1988). Much like Mr. Jain enjoys at BHRG, Mr. Buffett has a capital base and reputation that gives him a favored perch from which to make investments. When a financial institution wants the world’s most credible backstop, Mr. Buffett gets a call. The terms and structures of Berkshire’s investments in Goldman Sachs, GE Capital and Bank of America, included attractive cash dividends and warrants. For Berkshire, the deals were relatively low risk and high return.
After Berkshire’s purchase of Heinz, we estimate that the company will hold $35bn of cash, well above the $20bn cash cushion that Mr.
Buffett has pledged to hold. Guessing what’s next is exceedingly difficult, although we can narrow down the possibilities. Mr. Buffett does not go looking for something that Berkshire “needs.” Add-on deals are done regularly, but typically by the operating subsidiaries themselves. Last year, for example, Marmon made several low-profile acquisitions.
Mr. Buffett has also declared that there is no tax or accounting need for more underwriting operations, although it remains a business he clearly likes. He also prefers U.S. businesses and likes businesses in which it is easy to see “value add” for the customer. We would expect deals of significance, at least $10bn, to be a threshold. In addition, while Mr. Buffett has a reputation for value investing, he is not known for buying “broken” companies in need of restructuring.
